Efficient Markets Chapter 12 Charles P Jones Investments

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Efficient Markets Chapter 12 Charles P. Jones, Investments: Analysis and Management, Tenth Edition, John Efficient Markets Chapter 12 Charles P. Jones, Investments: Analysis and Management, Tenth Edition, John Wiley & Sons Prepared by G. D. Koppenhaver, Iowa State University 12 -1

Efficient Markets n n n How well do markets respond to new information? Should Efficient Markets n n n How well do markets respond to new information? Should it be possible to decide between a profitable and unprofitable investment given current information? Efficient Markets Ø The prices of all securities quickly and fully reflect all available information 12 -2

Conditions for an Efficient Market n Large number of rational, profitmaximizing investors Ø Ø Conditions for an Efficient Market n Large number of rational, profitmaximizing investors Ø Ø n n Actively participate in the market Individuals cannot affect market prices Information is costless, widely available, generated in a random fashion Investors react quickly and fully to new information 12 -3

Consequences of Efficient Market n n n Quick price adjustment in response to the Consequences of Efficient Market n n n Quick price adjustment in response to the arrival of random information makes the reward for analysis low Prices reflect all available information Price changes are independent of one another and move in a random fashion Ø New information is independent of past 12 -4

Market Efficiency Forms n Efficient market hypothesis Ø n To what extent do securities Market Efficiency Forms n Efficient market hypothesis Ø n To what extent do securities markets quickly and fully reflect different available information? Three levels of Market Efficiency Ø Ø Ø Weak form - market level data Semistrong form - public information Strong form - all (nonpublic) information 12 -5

Weak Form n n n Prices reflect all past price and volume data Technical Weak Form n n n Prices reflect all past price and volume data Technical analysis, which relies on the past history of prices, is of little or no value in assessing future changes in price Market adjusts or incorporates this information quickly and fully 12 -6

Semistrong Form n n n Prices reflect all publicly available information Investors cannot act Semistrong Form n n n Prices reflect all publicly available information Investors cannot act on new public information after its announcement and expect to earn above-average, riskadjusted returns Encompasses weak form as a subset 12 -7

Strong Form n n n Prices reflect all information, public and private No group Strong Form n n n Prices reflect all information, public and private No group of investors should be able to earn abnormal rates of return by using publicly and privately available information Encompasses weak and semistrong forms as subsets 12 -8

Evidence on Market Efficiency n Keys: Ø Ø n Consistency of returns in excess Evidence on Market Efficiency n Keys: Ø Ø n Consistency of returns in excess of risk Length of time over which returns are earned Economically efficient markets Ø Assets are priced so that investors cannot exploit any discrepancies and earn unusual returns n Transaction costs matter 12 -9

Weak Form Evidence n Test for independence (randomness) of stock price changes Ø Ø Weak Form Evidence n Test for independence (randomness) of stock price changes Ø Ø n If independent, trends in price changes do not exist Overreaction hypothesis and evidence Test for profitability of trading rules after brokerage costs Ø Simple buy-and-hold better 12 -10

Semistrong Form Evidence n Event studies Ø Ø Empirical analysis of stock price behavior Semistrong Form Evidence n Event studies Ø Ø Empirical analysis of stock price behavior surrounding a particular event Examine company unique returns n n n The residual error between the security’s actual return and that given by the index model Abnormal return (Arit) =Rit - E(Rit) Cumulative when a sum of Arit 12 -11

Semistrong Form Evidence n Stock splits Ø n Implications of split reflected in price Semistrong Form Evidence n Stock splits Ø n Implications of split reflected in price immediately following the announcement Accounting changes Ø n Quick reaction to real change in value Initial public offerings Ø n Only issues purchased at offer price yield abnormal returns Announcements and news Ø Little impact on price after release 12 -12

Strong Form Evidence n Test performance of groups which have access to nonpublic information Strong Form Evidence n Test performance of groups which have access to nonpublic information Ø Ø n Corporate insiders have valuable private information Evidence that many have consistently earned abnormal returns on their stock transactions Insider transactions must be publicly reported 12 -13

Implications of Efficient Market Hypothesis n n What should investors do if markets efficient? Implications of Efficient Market Hypothesis n n What should investors do if markets efficient? Technical analysis Ø n Not valuable if weak form holds Fundamental analysis of intrinsic value Ø Ø Not valuable if semistrong form holds Experience average results 12 -14

Implications of Efficient Market Hypothesis n For professional money managers Ø Less time spent Implications of Efficient Market Hypothesis n For professional money managers Ø Less time spent on individual securities n n Ø Passive investing favored Otherwise must believe in superior insight Tasks if markets informationally efficient n n Maintain correct diversification Achieve and maintain desired portfolio risk Manage tax burden Control transaction costs 12 -15

Market Anomalies n n Exceptions that appear to be contrary to market efficiency Earnings Market Anomalies n n Exceptions that appear to be contrary to market efficiency Earnings announcements affect stock prices Ø Ø Adjustment occurs before announcement but significant amount after Contrary to efficient market because the lag should not exist 12 -16

Market Anomalies n Low P/E ratio stocks tend to outperform high P/E ratio stocks Market Anomalies n Low P/E ratio stocks tend to outperform high P/E ratio stocks Ø Ø n Low P/E stocks generally have higher riskadjusted returns But P/E ratio is public information Should portfolio be based on P/E ratios? Ø Could result in an undiversified portfolio 12 -17

Market Anomalies n Size effect Ø n Tendency for small firms to have higher Market Anomalies n Size effect Ø n Tendency for small firms to have higher risk -adjusted returns than large firms January effect Ø Ø Tendency for small firm stock returns to be higher in January Of 30. 5% size premium, half of the effect occurs in January 12 -18

Market Anomalies n Value Line Ranking System Ø Advisory service that ranks 1700 stocks Market Anomalies n Value Line Ranking System Ø Advisory service that ranks 1700 stocks from best (1) to worst (5) n Ø 1980 -1993, Group 1 stocks had annualized return of 19. 3% n Ø Probable price performance in next 12 months Best investment letter performance overall Transaction costs may offset returns 12 -19

Behavioral Finance n n n Rationality as a principle of behavior Are there systematic Behavioral Finance n n n Rationality as a principle of behavior Are there systematic deviations from the norms of rationality? How do human beings make decisions? Ø Distortion throughout the process of decision-making n Ø In making predictions, perceiving the environment Marriage of psychology and finance 12 -20

Conclusions About Market Efficiency n Support for market efficiency is persuasive Ø Ø n Conclusions About Market Efficiency n Support for market efficiency is persuasive Ø Ø n Much research using different methods Also many anomalies that cannot be explained satisfactorily Markets very efficient but not totally Ø To outperform the market, fundamental analysis beyond the norm must be done 12 -21

Conclusions About Market Efficiency n If markets operationally efficient, some investors with the skill Conclusions About Market Efficiency n If markets operationally efficient, some investors with the skill to detect a divergence between price and semistrong value earn profits Ø Ø n Excludes the majority of investors Anomalies offer opportunities Controversy about the degree of market efficiency still remains 12 -22

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